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2 Terrible Stocks I'd Avoid

Timothy Green, The Motley Fool

Investors often spend a lot of time trying to identify the best stocks for their portfolios. But it's just as important, perhaps even more important, to avoid the worst stocks. Nothing will kill your performance like a dud that loses most of its value.

Some beaten-down stocks can provide tremendous returns if the companies execute successful turnarounds. J.C. Penney (NYSE: JCP) and GameStop (NYSE: GME) are not those stocks. Here's why you should stay far away from these two terrible retailers.

A do not enter sign.

Image source: Getty Images.

J.C. Penney

The surprise resignation of former J.C. Penney CEO Marvin Ellison in May threw cold water on the department store's turnaround efforts. Ellison brought large appliances back to J.C. Penney, hoping that the company would benefit from the slow demise of Sears Holdings. But that initiative so far hasn't done much to boost sales: First-quarter comparable sales grew by just 0.2%. Given that J.C. Penney's annual sales are still more than 25% below 2011 levels, that's just not a very good result.

J.C. Penney has made progress in some areas. The company has been paying down its debt, funded in part by selling off assets. J.C. Penney retired $1.4 billion of debt during Ellison's tenure, bringing the total debt load down to about $4.1 billion. But with meager profits and free cash flow, knocking down the debt further will be tough. In 2017, J.C. Penney booked adjusted net income of $68 million. The company reported free cash flow of $213 million for the year, but that number included the sale of operating assets, which will obviously not recur. Excluding asset sales, free cash flow was just $59 million.

J.C. Penney is a retailer loaded with debt, struggling to grow sales, and producing minimal profits. The company paid $325 million in interest last year, about 2.6% of revenue. That may not seem too bad, but J.C. Penney hasn't managed a GAAP operating margin above 2.6% since 2011. If there's a recession or a downturn in consumer demand, J.C. Penney is in deep trouble.

A comeback for J.C. Penney isn't impossible. But it's becoming harder for me to imagine with each passing quarter.

GameStop

Video game retailer GameStop's core business is selling new and used games for the major game consoles. The used games business is a cash cow for the company, carrying a gross margin nearly twice that of the new games business.

But there's a problem: Console games are going digital, much like PC games did years ago. The days of buying physical discs and popping them into your PlayStation or Xbox are numbered. The next generation of game consoles may or may not have disc drives. But even if they do, subscription and streaming services may be the death knell for the physical game disc.

GameStop has attempted to diversify the problem away, acquiring mobile phone stores under its Spring Mobile brand. But that strategy blew up when the company took a massive $358 million asset impairment charge and a $32.8 million goodwill impairment charge in the fourth quarter of last year. The total write-off was equivalent to more than five times the annual adjusted operating income for the whole technology brands segment. The company has now paused further investments and acquisitions.

GameStop is actively considering buyout bids, so there's some hope that the stock could recover some of its losses. Shares of the retailer have lost about 75% of their value since peaking in late 2013. But with the company careening toward an existential crisis, I don't think investors will be all that happy with the price if a buyer does emerge.

GameStop stock looks awfully cheap, trading for a single-digit multiple of earnings. But those earnings will likely disappear right along with physical discs.

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Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of GameStop and has the following options: short July 2018 $14 calls on GameStop. The Motley Fool has a disclosure policy.